Proposals to formalise the practice of banks holding more funds to cover potential losses on property lending could have a dramatic effect on both the commercial property market and the wider economy, a new report has claimed.28 Sep 2012

Property analysts Investment Property Databank (IPD) said that the practice, known as 'slotting', could "significantly exacerbate" economic risks by forcing banks to rid themselves of unsustainable property loans. The forced property sales that would result would "further depress" the property market, its report added, creating a "vicious cycle of further losses in loans secured by commercial property".

The proposed capital requirements, even for transactions 'slotted' into the lowest risk bracket, would raise the cost of finance for borrowers seeking low risk loans, the report added. Fewer projects going ahead as a result would lead to reduced construction activity, with "inevitable consequences" for the wider economy.

City watchdog the Financial Services Authority (FSA) first consulted on a standardised risk assessment model, intended to replace lenders' internal risk-based property lending models, last year. Its proposals would require banks to classify the risk of each income-producing real estate loan made into one of five 'slots': Strong, Good, Satisfactory, Weak or Default. Banks would be required to hold progressively higher amounts of capital against loans depending on their risk category. The FSA has since removed its suggested criteria, according to the IPD, but still plans to introduce reform.

The IPD study said that a problem with the system was the limited number of available slots. It used modelling techniques to examine how 3,442 commercial property assets valued at £56.6 billion before the financial crisis would perform against the new framework

The slots are set up in such a way that they discourage detailed risk analysis, the IPD said, leaving banks unable to take account of the observed risk characteristics of the commercial real estate market in order to develop an accurate risk profile for each transaction.

"Our intention here was to create an evidence-based study that allowed us to demonstrate the true effects of slotting using actual property data," said IPD managing director Phil Tily. "Based on our findings, slotting could cause serious harm if the impact on the property market and its relationship to the wider economy are not fully understood."

He added that analysts saw potential for "a more risk sensitive UK regulatory regime" which would instead "provide capital cost incentives to lend in an economically efficient and stabilising manner".

Commercial property expert Gerry Mulholland of Pinsent Masons, the law firm behind Out-Law.com, said that the introduction of slotting could "very well change the landscape" for lending by UK banks.

"The bluntness of the ' approach driving the need to set aside more risk-weighted assets coupled with industry wide commitments to deleverage will mean that a scarce, and expensive, product - money – will become ever-more scarce and expensive," he said. "Lenders have already looked long and hard at customer profiles so that fewer borrowers were meeting the demands of the new world, and slotting will exacerbate that."

He said that the practice could also mean that many of the loans requiring refinancing over the next 18-24 months would not be refinanced by the original lender. As banks sought to trade their existing debt portfolios, enforcement against defaulting borrowers by new finance providers could become increasingly common, he predicted.

"With a dearth of equity in the market, lenders are increasingly looking to trade the debt whether in a portfolio or on a connection basis," he said. "Buying and selling debt and then enforcing against defaulting borrowers will become a feature of the market."

According to the latest UK Commercial Property Lending Market report, published by De Montfort University in May, debt held against UK commercial property fell by 6.8% last year, from £228.1bn to £212.3bn. Between £72.5bn and £100bn of this debt will struggle to find refinancing on current market terms when it matures, according to the report.